Is de-risking risky?

Nersen Pillay

28 July 2017

The orthodoxy has been that younger savers should take more risk (e.g. hold more equities) but as people near retirement, they should play safe and have bonds and cash to preserve their capital. There is some sense in that view but could it be quite risky in a world of near zero interest rates?

As the Royal London Policy Paper “The Curse of Long Term Cash” demonstrated, holding too much cash has cost savers billions of pounds in lost potential gains and the value of their savings being eroded by inflation. Another problem with cash when interest rates are low is that rising average life expectancy means people may need their capital to grow for longer to meet their retirement needs. Moving to very defensive strategies removes significant potential benefits from compounding, risking income shortfalls.

Are bonds any better than cash as a store of value? Again, we start from a position of near zero interest rates in developed economies. If and when we see persistent higher inflation and interest rates rising in response, bonds are vulnerable to losses. It is clearly best to have limited duration exposure currently; de-risking into bonds carries particular risks. Similarly, it may not make sense to “annuitise” early and be stuck with low annuity rates forever.

What risk averse investors need are products with bond-like low volatility but with far better returns and less interest rate risk. And given some people nearing or post retirement often still need to have some growth in their portfolios, solutions giving equity-like returns but with much lower risk levels are in demand.

The orthodoxy has been that younger savers should take more risk (e.g. hold more equities) but as people near retirement, they should play safe and have bonds and cash to preserve their capital. There is some sense in that view but could it be quite risky in a world of near zero interest rates?

As the Royal London Policy Paper “The Curse of Long Term Cash” demonstrated, holding too much cash has cost savers billions of pounds in lost potential gains and the value of their savings being eroded by inflation. Another problem with cash when interest rates are low is that rising average life expectancy means people may need their capital to grow for longer to meet their retirement needs. Moving to very defensive strategies removes significant potential benefits from compounding, risking income shortfalls.

Are bonds any better than cash as a store of value? Again, we start from a position of near zero interest rates in developed economies. If and when we see persistent higher inflation and interest rates rising in response, bonds are vulnerable to losses. It is clearly best to have limited duration exposure currently; de-risking into bonds carries particular risks. Similarly, it may not make sense to “annuitise” early and be stuck with low annuity rates forever.

What risk averse investors need are products with bond-like low volatility but with far better returns and less interest rate risk. And given some people nearing or post retirement often still need to have some growth in their portfolios, solutions giving equity-like returns but with much lower risk levels are in demand.

Source: Expected risk and return based on RLAM’s medium term capital market assumption as of March 2017. *Please note that this does not reflect the actual performance of the RL Funds and should be used for information purposes only, not as a reliable indicator of future performance.

The chart above shows the benefits of diversification in terms of risk and return for different asset allocation benchmarks.

A conservative strategy holding mostly bonds and cash (see the orange oval) has an expected return less than 1% on top of inflation with expected risk of around 4% per annum. By diversifying and holding a multi asset fund with 25% of assets in equities, property and commodities gives far better expected returns with very little increase in volatility. So, a less conservative fund could offer a much better risk-return trade off because of the power of diversification.

Similarly, a pure equity portfolio would be expected to generate returns of around 7% above inflation with historic risk of around 17%, according to our data. By diversifying, say allocating 10 to 25% to Store of Value assets, savers could potentially get equity-like returns but with far lower expected volatility

De-risking into cash and bonds carries its own risks. Even into retirement, people often need to still retain some growth element in their portfolios.

Because de-risking can be risky, the power of diversification can play an important role. The Royal London Global Multi Asset Portfolios (GMAPs), a range of risk rated funds, aim to offer diversification across the risk return spectrum.

The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. For more information concerning the risks of investing, please refer to the Prospectus and Key Investor Information Document (KIID). The views expressed are the author’s own and do not constitute investment advice.